Preferred securities: from active management to sustainable investing
The U.S. Federal Reserve kick-started the tapering of its quantitative easing program in November and is expected to resume its tightening monetary cycle soon. While this may increase market volatility, preferred securities should remain a compelling asset class in 2022. However, as we expect U.S. rates to rise only modestly, this probably won’t affect investors’ appetite for yield. As ever, we should navigate any uncertainties with active management and credit selection while considering environmental, social, and governance factors.
Resilient performance despite market headwinds
News concerning record-high daily COVID-19 cases and new variants, as well as rising U.S. inflation and U.S. Federal Reserve (Fed) rate hike expectations, have seen the 10-year U.S. Treasury yield surge year to date. Yet preferred securities, with their high-yielding buffer and strong credit fundamentals, were resilient against other major fixed-income sectors during these uncertain times. As of November 30, preferred securities posted a 1.91% return, while U.S. high-yield bonds and U.S. investment-grade corporate bonds posted returns of 3.42% and -0.78%, respectively.¹
A positive environment for preferred securities
The outlook for preferred securities in 2022 looks positive. The U.S. economy has recovered nicely and continues to improve. Fiscal policy has been supportive and monetary policy is likely to remain so in 2022. Crucially, we’re not overly concerned about inflation over the longer term and believe we’re still in a lower-for-longer interest-rate environment. Plus, there remains substantial global demand for yield, with U.S. yields looking particularly attractive. In turn, this should help maintain relatively low rates. All of this results in a positive environment for preferreds, with credit spreads remaining stable and rates low.
Given that the Fed had started tapering in November, we think it’s inevitable that volatility will increase. During this time, active management is going to become increasingly important, and we have many tools at our disposal to take advantage of the expected volatility.
Our first tactic is to increase the weighting of fixed to floating-rate securities versus fixed-for-life securities, which are substantially held in preferred exchange-traded funds (ETFs). These are sensitive to flows from retail investors. However, US$1,000-par preferreds are held mainly by institutions with relatively stable movements. In addition, many US$1,000 preferreds are fixed to floating-rate securities, whereby during the first five years, the security will have a fixed coupon, but then float at a spread over a benchmark. This offers investors some coupon protection, even in a rising rate environment.
Another method is to lower the duration of the preferred securities portfolio to mitigate the effect of a rising rate environment. As rates bottomed out, we began trimming the duration from over 7 years in 2018 to 4.16 years at present.²
Moreover, we take a proactive approach to sector allocation and diversification, which a passive ETF cannot do. Unlike many preferred funds and certainly preferred ETFs with a significant weighting in the financial services sector, we’re currently far more diversified with overweight exposures in the utilities, energy, and communications sectors.
In addition to alpha generation, investors are becoming increasingly conscious of sustainable investing factors. As more information is provided on the environmental, social, and governance (ESG) practices of companies, analysis of these factors has featured more prominently in our investment process. ESG is an important element that explains why we’re significantly overweight in the utilities sector.
Utilities demonstrate how improving ESG profiles can deliver outperformance
Utilities really are at the forefront of the energy transition occurring in the United States. Twenty years ago, utilities generated close to 50% of their electricity from coal generation. Nowadays, more and more U.S. states have realized that one way to help fight against climate change is to deemphasize coal generation and encourage renewables.
So from an ESG standpoint, the utilities sector is now one of the leading segments of the S&P 500 Index. Because U.S. utilities are regulated, they earn a regulated return on any investments they make in transmission lines and generation. Since there’s pressure on states to reduce carbon emissions, potential investments in renewable energy are likely to be approved.
Our credit analysts spend a lot of time studying ESG considerations and have developed a proprietary ESG scoring system. We then incorporate the scores into our relative value analysis. Companies with improving ESG profiles tend to outperform, particularly in the utilities sector. We’ve identified several names that have outperformed because their renewables push has helped boost their ESG scores.
We see tremendous value in the utilities preferred space, as many of these securities aren’t trading on their underlying fundamentals:
- From an economic standpoint, the utilities sector has limited exposure to the coronavirus.
- Common equity valuation multiples among utilities are at their lowest levels in a decade. We believe the convertible preferred securities of utility issuers will benefit as valuation multiples rise.
- Utilities could earn a regulated return, depending on what the state regulator allows. This could be between 9.00% and 9.75%.
- We believe that U.S. President Joe Biden will provide incentives to encourage renewable energy investments, resulting in even more visible earnings and cash flows over the next few years.
The energy sector stands out amid a recovering global economy
Under a scenario where the global economy continues to improve, we expect recovery plays to outperform. Energy would be a beneficiary of any economic upturn. In fact, we’ve already seen this play out, particularly in the energy space, as credit spreads tightened significantly this year. Indeed, energy credit spreads are expected to tighten further, as many energy preferreds are still trading below pre-COVID-19 levels.
It’s important to note that our preferred energy names don’t have direct commodity price exposure, as they’re midstream companies that transport oil or gas in their pipelines. We hold a favorable view for the following reasons:
- Many of these companies are diversified into different areas of the midstream space, such as natural gas pipelines, gasoline pipelines, and storage.
- We believe natural gas has better long-term growth prospects than oil. Since it’s difficult to build energy infrastructure in the United States, this will result in higher average natural gas prices and places a greater value on existing energy infrastructure.
Financial services should benefit from higher rates
The financial services sector is expected to be another beneficiary of the improving economic environment, given the solid fundamentals of banking and insurance companies.
Higher interest rates are generally favorable for these firms. As yields moved higher over the past year, the earnings of financial service companies have improved markedly. We also see value in the sector because the market isn’t recognizing the sector’s balance sheet strength, and yields are expected to remain stable.
Default rates should remain low
We think that very few, if any, preferreds will default in 2022. Historical default rates among preferred securities have been low,³ primarily because issuers are generally well-established, high-quality companies with solid balance sheets.
The economic environment should continue to improve as the world becomes fully vaccinated. This should lead to further credit spread tightening, which will provide positive support for preferred prices. Most investors don’t realize that preferreds are less interest-rate sensitive due to their callable features and fixed to floating-rate structures. In a transitioning market, as the Fed begins to taper its asset purchases, we believe that active management and credit selection with a consideration of ESG factors will be vital to the outperformance of preferred securities.
1 Manulife Investment Management, Bloomberg, as of November 30, 2021. Returns in U.S. dollars. Preferred securities are represented by the ICE BofA U.S. All Capital Securities Index. U.S. high-yield bonds are represented by the ICE BofA U.S. High Yield Index. U.S. investment-grade corporate bonds are represented by the ICE BofA U.S. Corporate Index. It is not possible to invest directly in an index. Past performance is not indicative does not guarantee future results. 2 Manulife Investment Management, as of November 30, 2021. 3 Between 1990 and 2020, default rates for global high-yield bonds and preferred securities were 4.07% and 0.32%, respectively. The default rate for global high-yield bonds is sourced from Moody's Investor Services, as of December 31, 2020. The default rate for preferred securities between 1990 and 2017 is sourced from Wells Fargo. Default rates for preferred securities from 2018 were calculated by Manulife Investment Management based on the ICE BofA U.S. All Capital Securities Index.
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